The central premise behind federal laws prohibiting insider trading laws is to uphold the public integrity of the financial markets. To make a rough analogy, it's the difference between placing your bet at the roulette table of Bellagio compared to the one in the back alley at the traveling carnival. While the odds of winning are never in your favor at either location, there is an extremely high degree of confidence that when you win in Vegas, you will be paid. The confidence in the regulation of the casino industry attracts money. People will still play when they know that they're at an advertised disadvantage - that's the challenge and the reward of the game.

Nobody expects Main Street to match the sophistication level of Wall Street when it comes to understanding capital markets. The investor who spends a few hours a week tracking stocks, on average, will know less than the professional traders who study the markets 100 hours a week. People expect the financial service industry to outperform the general public. The general principle, however, is that the same information is open and available to all of us - they just have more time and expertise to read, digest, understand, and analyze it.

The focus of many high profile insider trading investigations happens in aberrations of the market. When a stock collapses and everybody loses money, the person that managed to avoid a tremendous financial loss is immediately suspect. The Japanese having a saying for this phenomenon that can be traced back to Confucius: "The tallest blade of grass is the first to be cut."

Martha Stewart's troubles began when her friend Sam Waksal confided in her that ImClone’s cancer drug had been rejected by the Food and Drug Administration. Before this information was made public, Martha Stewart had her broker sell her 4000 shares. She avoided the financial loss, but immediately raises suspicion on why she sold her shares when nobody else did.

Mark Cuban is under investigation for selling 600,000 shares of Mamma.com hours after allegedly being tipped him off by company insiders that the stock price was going to drop the next day. He avoided more than $750,000 in losses, but again, he attracted the attention of the SEC who wanted to know what information formed the basis of his decision to sell when nobody else in the market took the same action he did. It has been reported that his defense will be that he stated to a Mamma.com officer that his intention was to sell during the same phone conversation during which he allegedly received the insider information.

The crime of insider trading occurs when a person avoids a loss or makes a profit based upon material, non-public information. Section 10(b) of the 1934 Securities Act and SEC Rule 10b-5 are the most significant statutes governing securities fraud. Rule 10b-5 lists the basic elements of the offense:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Previously the person had to have a duty or obligation of confidentiality in order to be liable for insider trading, but this legal distinction is becoming irrelevant as people can be held liable under the theory of misappropriation. SEC rule 10b5-1 clarifies the ambiguities that hampered insider trading prosecutions in the past:

General. The "manipulative and deceptive devices" prohibited by Section 10(b) of the Act and Rule 10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.

Definition of "on the basis of." Subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is "on the basis of" material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.

It is absolutely legal for people with knowledge about a company to make intelligent decisions when buying or selling stock. So long as trades are reported to the SEC and the basis of the trade is on public information, no crime has been committed. SEC rule 10b5-1 enumerates two affirmative defenses:

Subject to paragraph (c)(1)(ii) of this section, a person's purchase or sale is not "on the basis of" material nonpublic information if the person making the purchase or sale demonstrates that:

Before becoming aware of the information, the person had:

Entered into a binding contract to purchase or sell the security,

Instructed another person to purchase or sell the security for the instructing person's account, or

Adopted a written plan for trading securities;

The contract, instruction, or plan described in paragraph (c)(1)(i)(A) of this Section:

Specified the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold;

Included a written formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold; or

Did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; provided, in addition, that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when doing so; and

The purchase or sale that occurred was pursuant to the contract, instruction, or plan. A purchase or sale is not "pursuant to a contract, instruction, or plan" if, among other things, the person who entered into the contract, instruction, or plan altered or deviated from the contract, instruction, or plan to purchase or sell securities (whether by changing the amount, price, or timing of the purchase or sale), or entered into or altered a corresponding or hedging transaction or position with respect to those securities.

Paragraph (c)(1)(i) of this section is applicable only when the contract, instruction, or plan to purchase or sell securities was given or entered into in good faith and not as part of a plan or scheme to evade the prohibitions of this section.

A person other than a natural person also may demonstrate that a purchase or sale of securities is not "on the basis of" material nonpublic information if the person demonstrates that:

The individual making the investment decision on behalf of the person to purchase or sell the securities was not aware of the information; and

The person had implemented reasonable policies and procedures, taking into consideration the nature of the person's business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material nonpublic information. These policies and procedures may include those that restrict any purchase, sale, and causing any purchase or sale of any security as to which the person has material nonpublic information, or those that prevent such individuals from becoming aware of such information.